If you want to get into a fight online, just bring up rent control. Yep, it’s a polarizing topic. But before we duke it out, this post isn’t about whether rent control should exist or not. No, it’s written to lend insight into how we might value properties now that rent control is legal in California. Keep in mind there are now several states with rent control, so this is something to watch as a trend.
Today I’ve invited a Bay Area appraiser, Denis DeSaix, MAI, SRA, to help shed light on the issue of rent control in real estate. Denis is an industry leader, generous educator, critical thinker, and former Marine. Please join me in welcoming him and be sure to visit his website.
LONGER: This is longer on purpose. Digest slowly or focus quickly on what interests you. I realize this is tedious too, but that’s the nature of the beast. If you work in real estate, it’s going to take time and effort to understand this.
Ryan: Tell us about your background and experience with rent control.
Denis: I’m a commercial and residential real estate appraiser with 25+ years’ experience in the valuation of residential income properties located in in jurisdictions with varying degrees of rent control. I also own a 6-unit apartment in Santa Monica, CA, a jurisdiction with a very strict rent control ordinance.
Ryan: What would you say to those worried about rent control?
Denis: There are three stakeholders I’d address:
To the current owners, the good news is that the state’s rent control ordinance could have been much more onerous (compare the state’s law to such jurisdictions as San Francisco or Santa Monica). I’d also say that as far as rental increases go, if you are at or close to a market rate at the end of 2019, you should be in relatively good shape in the short- to mid-term; the state’s law allows an increase of 5% plus the rate of inflation, with a maximum cap of 10%. In the current low-inflation environment, you should be able to adjust the rent to keep up with any inflationary increase of expenses as well as with market changes up to 5%. If inflation climbs to 5% or more, then your ability to keep-up will become constrained. On the downside is there are new eviction-restrictions. After one year’s tenancy, a tenant becomes protected and some evictions will require a relocation fee (one month’s rent).
To current and prospective tenants, once you’ve established one-year’s tenancy you will be eligible for eviction relocation under certain circumstances. However, be prepared for changes in the way vacant units will be rented. For example, it is common in many markets for vacant units to be rented for one-year and then go to a month-to-month lease. It will likely become more common for vacant units to be rented on a shorter term for the first year; this will give owners some ability to not renew the lease before the one-year tenure. Another positive is relative certainty of rental increases going forward; in sum, your rent cannot be increased more than 5% + the local inflation rate and the maximum increase is 10%.
To buyers and sellers, I’d say the evaluation of a property’s contract rental rates has gained additional importance. While this has always been true in the more heavily regulated rent control markets, it can make a difference in newly controlled markets. The greater the disparity between protected rents and market rents, the longer it will take to stabilize that difference; this can have an impact (downward) on a property’s value. In addition, some buyers specialize in renovating older rental units or those that have not been adequately maintained will now have an additional cost for such projects as tenant relocation will probably be required.
Ryan: What effect have you seen in your market due to rent control?
Denis: The state law is too new for me to see any direct impact so far. However, for more established rent control jurisdictions, the impact is directly related to the level of existing restrictions. For example, the City of Sacramento recently passed its own rent control ordinance. In its version, properties built before 01/01/1995 were subject to rent control. Properties that are covered under the City’s ordinances will remain under those ordinances. But properties that are built after 01/01/1995 will now be covered under the state ordinance.
However, in general, I think it is fair to say the impact on the market is directly related to the severity of restrictions of the rent control ordinance. Where rent increases are very limited, it is common to see smaller, independent owners deferring maintenance as well as delaying updates and renovations. In other words, a property begins to deteriorate faster than otherwise. This continues until a new owner takes over. And we see another dynamic as well; ownership migrates from smaller, local investors to a more sophisticated and many times out-of-town ownership entity. In other areas where rent control ordinances are less restrictive, the above scenario is less likely to occur or occurs over a longer period.
Ryan: Would you say the effects are all negative or are there some positives?
Denis: There are specific benefits to tenants who fall under rent control: certainty of knowing how the maximum rental increase will be calculated and certainty of knowing what protections one has in the case of an eviction action.
Are there benefits to property owners? Most studies agree that stable occupancy is the most tangible benefit to the property owner. Logic would argue that there is a tipping point, however. While historically many property owners (especially if they were smaller and local) discounted the rent to existing tenants to retain them and keep the units occupied, discounting below a certain point would be unnecessary. At that point, there is no benefit to the property owner… only a cost. Therefore, at some point, the disparity between market rent and controlled rent would eliminate the benefit of stable occupancy.
Ryan: What type of investors tend to buy in rent controlled markets?
Denis: The investor profile is dependent on the severity of the rent control: Since rent control can significantly impact the revenue stream and operating costs of a unit/building, the more significant the restrictions, the greater the sophistication and wherewithal of the investor. This is part of the ownership-migration I mentioned earlier. In some markets, the investor of an older multifamily property is not counting on current income at all; they are planning on redevelopment or conversion (say, from a 4-unit apartment to a 4-unit condominium project) to be their payday; such an investor needs a certain level of expertise and capacity to manage and finance an endeavor like that.
Now, to be clear, this doesn’t mean that a small, local investor should not invest in rent-controlled properties. As I said, the state law is at the lower-end of the severity range as far as its restrictions and well within a basic real estate investor’s wheelhouse to understand and evaluate. But as I also mentioned, the controlled rents vs. market rent disparity takes on a more important part of the analysis, as would accumulated deferred maintenance and needed repairs or replacements. A back-of-the-envelope quick estimate may no longer be appropriate and a more formal evaluation of projected income, turn-over, expenses, and replacement/repair costs might be in order.
Ryan: By the way, if anyone needs a visual to help understand differences between California & Sacramento rent control, here you go. In most cases rent control will not apply to single family homes unless they’re owned by a REIT, corporation, or LLC (there could be other slight variations). This is important because we often hear rent control applies to every property, but that’s not accurate. Thank you Erin Stumpf for letting me post this image.
Ryan: What stats if any do you suggest locals watch in order to measure any impact due to rent control?
Denis: Actual market rents vs. what the average controlled rent is. We can use 2019 as the base rent and benchmark to that. One thing to keep in mind: Under the state law, the most widely tracked properties to be exempt under rent control will be the newer buildings (15 years old or less from the current year). Therefore, most “market rents” reported could include newer and, presumably, superior rental properties vs. the average rental which may be built 1950-1980.
Another metric to watch is redevelopment of older units to newer units. If that accelerates, it may be evidence that the disparity between rent controlled rates vs. market rates are such that it is financially feasible to tear down an otherwise functionally usable building in order to get non-controlled rents.
Ryan: What type of change do you think might be in store for Sacramento?
Denis: Sacramento’s rent controlled ordinance is very similar to the state’s new law in terms of rent increases. The eviction rules are slightly different but Sacramento does not require relocation assistance as long as the rules are followed. So I don’t see any immediate and significant impact to Sacramento vs. the state law. However, two things to keep in mind:
1) Sacramento’s ordinance is set to sunset (expire) at the end of 2024; if it does, then the state’s law would automatically take its place on January 1, 2025 and be valid through the end of 2030.
2) Sacramento’s ordinance has a set-date for new-construction exemption. The City’s ordinance does not apply to properties built after 1995; in other words, they are exempt from Sacramento Rent Control.
The state law, however, has a rolling date; in other words, it exempts properties built within the last 15 years. In 2020, buildings with a construction date of 2005 or later will be exempt. In 2021, the exemption covers properties built after 2006 but those built in 2005 would no longer be exempt (hence, the 15 year exemption rolls with the current date). Because the state law applies to all properties that are exempt from an existing rent control ordinance, in Sacramento, the formerly exempt properties built from 1995 through 2004 will be required to comply with the state law.
The take-away is this: If a property is covered by an existing rent control ordinance, then the existing law is the controlling regulation. If a property is exempt under an existing rent control ordinance but would be covered under the state ordinance, then the state law is the controlling regulation. In the case of Sacramento, the impact will be to those buildings constructed from 1995 through 2004. The next event will be if Sacramento lets their law sunset in 2024; if that happens, then the state law becomes the new regulation.
Ryan: When valuing multi-unit properties, do you see a price difference between properties in light of rent control?
Denis: Yes. When I have rents that are below market, how long it takes me to get those rents to market is going to impact the value of the property. If I can get the rents to market in a relatively short time, there may be little if any impact. If it takes me longer to get the rents to market, then I’m going to pay less for that property than I would if it were at market. Why? Because it is going to take time and effort to get the rents to market (plus there is some risk involved; I might have miscalculated and it could take me longer or cost me more than I originally thought) so why should I pay the same price I would if I didn’t have all that to worry about?
In rental markets where lease-up time is relatively short and vacancy rates relatively low, vacant units can have the same value as if it were rented at market (the presumption is it can be rented quickly at the market rate).
Ryan: Any advice when choosing comps?
Denis: Appraisers are usually very good at defining a subject’s competitive market area and then the physical elements of comparison. We can identify with a high level of confidence the competitive market area, considering all the important locational influences. If our property is a 50-year old house with 3br/2.5ba, on an 8,000sf lot, we are excellent at matching those physical features. We are also very good at matching condition differences and specific location differences like backing to a busy street. Rent control is going to introduce an element of comparison that some of us may not be familiar with and are going to have to get up to speed as quickly as we can. That element is restricted rents and that is an economic characteristic that is not accounted for in the physical characteristic differences.
Consider the following: I may have two rental properties located side-by-side and almost equal in every physical and location-based element of comparison. Typically, it is the physical or locational differences which impact rent, but in this case the two buildings are effective the same. However, one has significantly below market rents that will take some time to get to market and the other has all of its units rented at market. They are twins in terms of physical characteristics but very different in terms of economic characteristics. Assume that the buyer of this property is an investor. Is the buyer going to pay the same price for the below-market-rent property as s/he would for the at-market rent property? The answer is clearly no. This dynamic needs to be identified when it exists and its impact on value needs to be analyzed.
Also, for income properties subject to rent control, the appraiser is going to have to consider what rent control ordinance applies (local or state)? There is a significant difference in the rent control ordinances of San Francisco and South San Francisco even though the two cities are next door to each other. San Francisco is very restrictive; South San Francisco has no rent control so it will fall under the state regulation in 2020. Therefore, without additional research, using a rent-controlled property from one jurisdiction as a comparable in another jurisdiction could be inappropriate.
The bottom line is appraisers will have to ensure that they are matching the economic characteristic of rental income due to regulation rather than assuming such differences are captured in the physical/locational adjustments.
Ryan: What mistakes have you seen real estate agents make regarding rent control?
Denis: Most mistakes are due to an unfamiliarity of how rent control impacts value. The real danger is if the agent doesn’t fully understand how rent control can impact the income-stream they are going to misprice the property. Again, back to the “all other things being the same” between two properties covered by the same rent control ordinance; one rented at market and the other at a below market rate due to rent control:
If they use the at-market transaction’s cap rate to price the rent-controlled listing, there is a risk that the property will be underpriced. Here’s the math:
Market Rate property generates $100,000 net income and sells for $2,000,000; a cap rate of 5%.
Below Market Rate property generates $90,000 net income ($10,000/year less). Based on a 5% cap rate, it would be priced at $1,800,000. The difference is $200,000 in price. But assume I do a little deeper analysis and I feel confident that with normal tenant turn-over and with the ability to increase rents 5% + CPI, I think I can get to market rents in 3 years. To keep it simple, let’s say the first year I’m negative $10,000, the second year I’m negative $5,000, and the third year I’m negative $2,500 (at the end of year three, I’m at market). I’ve only lost $17,500 in income over three years but I’ve discounted the price $200,000.
Let’s flip the example. My below market rate property sells at $1,925,000; this is $75,000 less than it would if at market but it reflects the lost income of $17,500 and the additional expenses of releasing and updating the units plus some reward for taking on the risk involved. My in-place net income was $90,000 when it sold for $1,925,000, which equates to a 4.68% cap rate (one can see why a below market rent property would have a lower cap rate than a market-rate property, all other things being the same).
If I apply that cap rate to the at-market property’s income ($100,000) I’ve now priced it at $2,138,000. In other words, this misapplied application results in an additional $138,000 more than what it should be. If I’m the seller, I’ve over-priced the property and if I’m the buyer, I’ve over-paid.
Ryan: What mistakes do you think appraisers make?
Denis: Here are the ones I commonly see:
– Failure to properly identify & summarize the rent control restrictions when they exist
– Failure to properly identify and evaluate their impact on value
– Failure to consider their impact in all the approaches to value
Let’s put this into a residential context and assume I’m valuing a 4-unit property. For 4-unit valuation, cap rates are not ideally utilized when analyzing income. A gross rent multiplier is the most commonly used technique (some argue that GRM analysis is not a true income approach technique, but that argument doesn’t matter in this case). Lets’ further assume that my subject’s units are configured as 1br/1ba units and that the typical buyer for this type of property is an investor (the buyer is not going to purchase this to use for personal occupancy; they are purchasing for investment purposes).
The first thing I have to do is make sure I understand what rent control ordinance (if any) applies to this property and then summarize it. The state law doesn’t just apply to 2+ unit properties. SFRs and condos may be subject to rent control depending on the ownership entity (if owned by a REIT or corporation, of in some cases, if owned by an LLC where at least one member is a corporation). So if an appraiser receives an assignment to value a residential property and that residential property is a rental, the appraiser should take some steps to verify if it is subject-to or exempt from rent control ordinance; this means confirming with the client the ownership status to some degree and disclosing that confirmation-process in the appraisal report.
Next, if I have a rental that is subject to rent control, what does that mean? It means that I now must evaluate and analyze how those restrictions impact the subject’s value. Let’s assume my property is covered by the state law and I’m currently 6% below market with regard to my rents; will that impact value? Maybe, but here’s an argument why it likely wouldn’t in a moderately stable rental market: If rents are increasing 3% per year, and assuming inflation is less than 5% per year, I can make up that difference in 2-years. Will the market participants discount the price in this scenario? That needs to be confirmed at the local market level with those participants but analyzing the dynamic using the math can give us an indication of the significance of the difference.
My point here is that for some appraisers whose markets were not subject to rent control, there is a new dynamic which may require additional analyses than what was needed previously. And, in all cases, this dynamic needs to be reported when it is relevant given the assignment.
Ryan: Any other advice you’d give to the real estate community?
Denis: Non-real estate entities rely on us to be their experts in matters real estate. Whether we are consulting with an estate attorney or working with a buyer or seller, each of us brings to the table specialized knowledge to assist our clients in addressing their real estate needs. The state rent control ordinance represents a significant change in California’s residential-income real estate market. We must ensure that we stay up to speed on the changes that impact this segment of the market if we are to maintain our expertise and fulfill our role as a competent and trusted advisor.
Ryan: Anything else you want to say?
Denis: This new regulation represents a very significant change. Thanks for giving me the opportunity to share my thoughts and observations on this matter!
Ryan: Thank you so much. This was really valuable Denis. I appreciate you. Everyone, please visit Metrocal Appraisal’s website.
QUICK CLOSING THOUGHTS: There is lots to take in when it comes to rent control, so it’s going to take some time to understand it. My advice? Pay close attention to the letter of the law so you are speaking correctly about properties. On this note, be cautious about saying rent control applies to single family homes because it won’t in most cases in Sacramento and California (unless owned by a REIT, corporation, etc…). Most of all, watch the market closely so you’re in tune with what is happening with values.
——————– interview end ——————–
I hope this was helpful.
RESOURCES: Here’s an overview of rent control in California with a video link of Puneet Singh, an attorney, talking through new laws for the rental housing industry in 2020. Her talk is about an hour, so pop some popcorn and get to it if you wish. Also, here’s a tenant advocacy toolkit (PDF) that does a good job visualizing some of the details of AB 1482. It might be useful to print this file and read a few times to help digest information.
Questions: What if anything are you concerned about with rent control? What stood out to you most about the interview? Did we miss anything? I’d love to hear your take.